Adding a VAT

Josh Barro has a piece in favor of a Value Added Tax in Bloomberg. A VAT is a tax levied on business sales minus their inputs or costs, so all companies ‘adding value’ along the production chain pay the tax, but it is collected at the sale of the final consumer good. If you buy a sweater for $50 and the VAT is 10%, $5 of the $50 is the VAT.

In my book Balancing the Budget is a Progressive Priority, I didn’t suggest that we add a VAT, but I do think that it will take a substantial increase in tax revenue as a percent of GDP to ever have a balanced budget again. I suggest 21% of GDP, which is about 3 percentage points higher than the 40 year average, a level that is doable, but won’t be easy. Would a VAT be useful to consider? A key question, and a few thoughts.

  • Is the VAT viewed as a supplement to our current system of taxation (payroll taxes, personal and corporate income, excise taxes) or a replacement of some portion? I asked Josh Barro via twitter for his views, and he said he viewed the VAT as supplementing our current federal taxation regime, shown below. Individual income taxes and payroll taxes are the largest source of federal revenue, with corporate and excise taxes being much smaller (in percent of GDP terms).

Barro notes how difficult tax reform that increases revenue will be, whether it is in the individual or corporate income tax, because as much as people claim to support it in theory, most deductions and exemptions benefit those who are powerful. So, one strong positive of the VAT is that it could raise a substantial amount of revenue, and would not be as noticeable and its burden would be spread across all consumers. A negative is that it is a regressive tax (lower income have larger percentage of their income subjected to the tax).

I have suggested ending the corporate income tax, and treating dividends and capital gains as normal income, while raising the top personal income tax rate and thereby making it more progressive. I stand by the notion that the most important tax reform decision is determining what proportion of GDP will be collected in taxes. Within that overall level of taxation, distributional impacts are important. Currently, we have a regressive payroll tax and a progressive income tax as the two largest revenue raisers, so it could raise concerns to add another large regressive revenue raiser. Josh Barro has a follow up post in which he argues distributional/fairness concerns about the VAT are not as big a worry so long as you are not adding a VAT and doing nothing else. This argument makes sense at some level, but I haven’t read all the underlying work he cites, and Michael Linden is lots more skeptical on twitter about this and points to this document (that I need to read).

Whatever we concluded, this strikes me as the type of discussion we should be having; what level of tax will be collected to finance a plausible level of spending? Within that, what mix of taxes will be used? The hardest part of all this is imagining that our dysfunctional political system could ever have a reasoned discussion of these issues. That is demoralizing.

Author: Don Taylor

Don Taylor is an Associate Professor of Public Policy at Duke University, where his teaching and research focuses on health policy, with a focus on Medicare generally, and on hospice and palliative care, specifically. He increasingly works at the intersection of health policy and the federal budget. Past research topics have included health workforce and the economics of smoking. He began blogging in June 2009 and wrote columns on health reform for the Raleigh, (N.C.) News and Observer. He blogged at The Incidental Economist from March 2011 to March 2012. He is the author of a book, Balancing the Budget is a Progressive Priority that will be published by Springer in May 2012.

27 thoughts on “Adding a VAT”

  1. I think a VAT is a reasonable idea, but I’d really like to see some Pigovian taxes, particularly on carbon.

    1. Don, a VAT being regressive is generally counter-acted in countries that have it in three different ways:

      * Necessities of everyday life (such as groceries) are either entirely exempt from VAT or taxed at a greatly reduced rate (the same also goes for books and such).
      * VAT taxation is combined with an otherwise more progressive taxation compared to what we have in America.
      * Cash transfers, from which low-income families benefit disproportionately, offset a good part of the regressive nature of the VAT.

      For example, Sweden, Denmark, and Norway have a standard VAT rate of 25%, but are not exactly examples of regressiveness, even though income taxes are hardly at the lowend, either, even for the middle class. That’s because you get a lot for your taxes that you would otherwise have to pay for yourself.

      Whether the last two (and most important) items could be introduced in America along with a VAT regime is an open question (personally, I’d consider it unlikely with the current state of the Republican party).

      What makes a VAT attractive is that it provides a fairly stable basis of taxation; a VAT is also comparatively difficult to evade (aside from VAT for services associated with highly individual transactions, such as having a car repaired).

      1. Why invent a regressive tax and then add layers of workarounds to fix the regressivity? Why not just use an actually progressive tax in the first place? It’s not obvious to me that the difficulty of evading the VAT (not yet demonstrated) justifies its other properties.

        1. A VAT has both advantages and disadvantages. Among its advantages are:

          * A VAT provides a more stable source of revenue than income or payroll taxes; income and payroll tax revenue fluctuates far more with the economic cycle. This is important for countercyclical measures or welfare (whose demands, if anything, increase during a recession).
          * As a tax, a VAT is fairly easy to administrate and difficult to evade (outside of the final retail level, evading a VAT requires collusion between businesses and provides little, if any, benefit for the actors).

          Note that introducing a VAT does not mean abolishing other, progressive taxes; a VAT is a component of an overall revenue scheme that stabilizes revenue.

          What makes me nervous is not the possibility of the introduction of a VAT but that I don’t necessarily trust our political actors to do that in a responsible way. I’m completely fine with using a VAT to expand our social safety net (which in and of itself would make the net effect progressive, not regressive), but not fine with using a VAT to further expand our corporate welfare state or to build a couple new aircraft carriers.

          1. Katja, isn’t there an argument that your first point is actually a disadvantage? On the federal level, we want revenue collection and spending to be counter-cyclical.

          2. Revenue SHOULD fall in a depression. Citizens have less ability to pay when the economy is bad. If government were deficit spending to fix the bad economy, the revenue problem would sort itself out. In other words, I think VAT is a solution to the wrong problem.

            I do take your point about VAT being hard to evade without collusion, at least in retail. I wonder to what extent the VAT would apply to theoretical producers like Karl Rove’s lawyer, or a corporate lobbyist, or other services consumed by the rich? “I’ll ghost write your autobiography for x, bill you for (x-y), plus the VAT tax on (x-y) dollars, and you pay the invoice plus y in cash under the table.” Guy providing the service makes a sale, guy receiving the service evades taxes. Seems about as hard to foil this plot as it is to detect undeclared income subject to income tax.

          3. Ben, that’s what I was trying to say? VAT revenues don’t go down as much during a recession, so government spending can be more stable (i.e., counter-cyclical) without adding as much to the debt.

            Don, citizens have less ability to pay, but consumer spending still goes down less than income. And there’s more to what a government needs to do during a recession than just deficit spending; it also has to support the freshly unemployed, for example. In a recession, a VAT becomes largely a redistributive measure: Money goes from those who can afford to spend to those who cannot. If you’re unemployed, you may be paying x% in VAT to the government, but 100% of your income comes from the government (assuming a functioning social safety net). Yes, deficit spending can also help an ailing economy (assuming you can convince Congress), but that’s no free lunch, either, even disregarding the political capital necessary.

            About VAT evasion: That’s basically the one scenario where it often happens. The benefits are slightly different, though: The person making the sale can keep it off the books (and thus not pay income tax on it), while the customer avoids paying VAT; the seller does not actually gain anything from the VAT avoidance, since VAT is just passed on to the customer and incremental in nature (that’s the “value added” part); it’s not quite a sales tax. But in the majority of cases, VAT evasion is still comparatively difficult (as opposed to income tax evasion) and does not really benefit a business much.

            In the end, let’s be clear about Don Taylor’s bigger point: If you want a government that can actually do things (rather than just administrating scarcity), that government needs sufficient revenues. Our current tax base is very low, so we don’t have what you could call a functioning social safety net (at least not with a straight face) and even our infrastructure is in tatters. If you’re fine with that, okay, no need to change anything, other than cutting spending more and watching America deteriorate. If you’re not, then you need to raise more revenue. TANSTAAFL. That’s the big difference between America and Europe (careful, minor hyperbole for rhetorical effect): Europeans hate paying taxes just as much, but they also know that the money for their welfare states has to come from somewhere. Americans largely want to have their cake and eat it, too (complete health insurance coverage without higher taxes or an individual mandate; and a pony, too). Second, if you think you can raise enough money by just making income tax more progressive and increasing corporate taxes, I doubt that’s going to work. Other countries not only have higher taxes for high income households, they also have higher taxes for low income households (of course, you also get something back — taxes that you pay do not disappear from the economy).

            In the end, I don’t know if a VAT’s advantages would outweigh its disadvantages. What I’m pretty sure of is that the tax base needs to be broadened. A VAT could be part of that, if done right; I’m not advocating that it should, I’m only saying that there’s nothing inherently wrong with the idea.

          4. “Europeans hate paying taxes just as much, but they also know that the money for their welfare states has to come from somewhere.”

            Apparantly, a lot of them think it doesn’t have to come from them personally though. The US has a higher tax compliance rate than any European country.

          5. CharlesWT: The US has a higher tax compliance rate than any European country.

            No, not really.

            US tax gap in 2006, as estimated by the IRS: about 14.5%.
            UK tax gap in 2008-10, as estimated by HM Revenue & Customs: about 8%.

            (There’s some genuine debate about the precision of these values, given that they have to be estimated using various methodologies [1], but there’s still a lot of daylight between 8% and 14.5%.)

            Tax compliance, to be clear, is not necessarily a result of the ethics (or lack thereof) of the nationals of any given country; it is more often a function of opportunity and incentive. Compliance for wages reported on W-2 forms or for FICA taxes is near 100%, for example; there just isn’t much room for cheating. Conversely, non-farm proprietor income for American businesses has only around 50% compliance, because it’s presumably comparatively easy to cheat and comparatively hard to get caught (and also has potential for genuine mistakes).

            What you may have seen are reports about the relative sizes of the so-called shadow economies of various countries; America is indeed believed to have a very small shadow economy (not surprising, given that this is expected for a country with a comparatively small welfare state), but that’s not the same thing as tax compliance.

            First of all, shadow economy estimates are fraught with imprecision and error due to the inherent difficulty involved in measuring them. Several estimates are high enough to be at least somewhat implausible (a shadow economy generating a claimed 20% of GDP through mostly part-time or low-paid jobs even when unemployment is low requires more explanation than just throwing a few values at a MIMIC model and/or M0 monetary supply estimates). There have also been order-of-magnitude differences between interview-based estimates of the economy and macroeconomic methods, not all of which can be explained by lying. My inner scientist always gets twitchy when the macroeconomic estimates are passed off as 100% reliable values. (A very nice and comprehensive survey paper covering the various methodologies used to estimate shadow economies can be found here — unfortunately, it’s in German.)

            Second, even where accurate, you cannot multiply the size of the shadow economy by the average tax burden and be done; not only is not all value generated by a shadow economy incur full income tax, VAT, and social tax liability; shadow economies typically operate in the realm of low-paid or part-time jobs, where the tax burden is comparatively low. For example, a German household that employs a part-time cleaning lady but fails to register her with the Minijob office only dodges 13.7% of taxes on what she is being paid; 10% of which can be claimed as a tax credit on their income tax return. So, the net loss to the government in such a case would be 3.7% of wages paid (the cleaning lady would not have to pay any taxes herself).

            [1] For income tax, the usual approach that the IRS/HMRC take is to compare tax returns with the results of random audits, for example, and extrapolate from the discrepancies. This is not necessarily fully accurate, since income can be hidden from audits also, and there’s also room for statistical error, but it’s about the best estimate we’re likely to get.

          6. Katja, good points. The following link has links to a couple of studies on tax compliance in various countries. Your points about methodologies, opportunity and incentive, enforcement levels, etc. would apply here as well. Accurate or not, the studies look to be pretty thorough.

            Personal Income Tax Compliance Rates
            United States: 83.1%
            United Kingdom: 77.97%
            Switzerland: 77.70%
            France: 75.38%
            Austria: 74.80%
            Netherlands: 72.84%
            Belgium: 70.15%
            Portugal: 68.09%
            Germany: 67.72%
            Italy: 62.49%
            Globally Speaking, American Taxpayers are Pushovers

          7. Charles, this article compares the US gross tax gap calculated by the IRS with estimates for European personal income taxes based on macroeconomic stats and microeconomic data (namely, the LIS). This goes beyond even apples and oranges comparisons; not only are the methodologies completely different and do not result in comparable numbers (the European study, for example, appears to still include a fair amount of legal tax avoidance in addition to illegal tax evasion), different kinds of taxes are being compared (the IRS tax gap also accounts for FICA taxes, self-employment taxes, corporate taxes, unemployment taxes, estate taxes, and excise taxes).

          8. Katja, we don’t disagree on the need to increase revenue, and I get that the money can’t come entirely from people other than me.

            We do disagree about taxation during a recession. You’re quite right that VAT would be a more stable source of revenue in a depression, but that feature is the opposite of counter-cyclical. It’s all very well, and quite sensible, for the government to maintain the social safety net in a depression, but those measures would be in spite of the fact that taxes during the depression, as a proportion of GDP, would be higher with a VAT. Given enough raw power we can drag a ball and chain along behind us; just don’t tell me the ball and chain make us go faster.

            The usefulness of stable revenue aside, I simply don’t see regressive taxation as just. The depression was created by rich people who have landed on their feet very nicely thank you, and working class people have been left to pay the bill yet again. And if you thought that in 2008 you were voting for somebody who would put handcuffs on some bankers and drag them off to federal pound-me-in-the-ass prison, you should be feeling not just angry, but also betrayed. Any tax reform plan that doesn’t explicitly and proudly redistribute wealth isn’t worth our time or our support.

  2. Don,

    What would be wrong with leveling the payroll tax in some way(s), like:

    1. Extending it to all earned income rather than the first $100K or so;
    2. Supplementing it with a reasonable securities trading tax earmarked for the Social Security and Medicare Trusts? Properly structured, this would reduce the ridiculous incentive for high-frequency trading.

    I like the idea of treating dividends as ordinary income, and I could be persuaded (by proper indexing) that capital gains should be treated that way too. I see no reason why a huge accumulation of credits should receive preferential tax treatment over a ditch-digger; I see plenty of moral reasons the ditch-digger ought to receive the preferential treatment.

    And what of estate taxes? No, Frank, they aren’t death taxes.

  3. Dennis,

    I like the idea of leveling the payroll tax, but only as a fallback position to eliminating the regressive payroll tax. I see no reason not to fund Social Security with regular income tax revenue, other than the political obstacles, and the Republicans would love to eliminate Social Security altogether whether it’s funded by a regressive tax or not.

    A securities trading tax makes sense, though I wouldn’t complicate it with rules about what could be done with the revenue thus generated.

    And while we’re off-topic I’d like to see a progressive net worth tax that kicks in at a net worth of about $1 million. (Strangely, I heard this was Donald Trump’s idea.)

    1. Maybe it’s just me, but I think eliminating the payroll tax would reduce support for Social Security. With most of us paying the employee’s contribution, we see it as something we’ve paid that in some sense belongs to us personally. If we fund SS from regular tax revenues, it’s very possible for people to see it as an even-more-explicit transfer of wealth to those people.

      Now, obviously SS is going to be funded in the future from regular tax revenues — to the extent that the Trustees are cashing in some of their Treasury securities it’s being funded that way now. But that is down in the wonky weeds.

      By earmarking a trading tax revenue, I was trying to make an explicit connection between income derived from exchanging bits of green paper and income earned by grading execrable student writing. I think you’re right, though. Institute a trading tax, and make it high enough to put a damper on high-frequency trading. Use the revenue wherever we most need it.

  4. I would suggest a tweak to the “eliminate the corporate tax” idea, as the right to accumulate income tax-free is quite valuable (your system would give corporations the tax structure of a 401(k)) and tends to benefit management relative to employees and owners. Charge corporate tax solely on undistributed GAAP/IFRS income, at the highest individual rate.

  5. @SamChevre
    If you ended corp tax, you would have to do so alongside some alterations of the personal income tax as well, so that people didn’t just make themselves corps and come up with ways to take money out that wasn’t salary, dividends, or capital gains. Would charging on undistributed be like the old N.C. ‘intangibles’ tax, that was held to be unconstitutional by NC Supreme Court? Yours may be a friendly amendment to what I suggest, and I think it gives incentive to go ahead and pass profitability along to workers and/or shareholders or to reinvest. correct? I mostly want to get away from the strange dance we now have whereby we (1) decry the high corp tax rate that (2) almost no corporation actually pays so that (3) this has raised no more than 13% of the federal receipts since 1980. It is not an efficient way to raise revenue, and there could be great political advantages for progressives to move in this direction. Maybe it would help with long term investment, not sure….corps have lots of cash now and not creating jobs.

    1. I’m not familiar with the “intangibles” tax issue, so I can’t speak to that question.

      My concern is not revenue-raising (I would expect my change to raise minimal revenue), but providing a strong incentive to distribute money earned as dividends rather than reinvesting it internally. (In other words, it’s MOSTLY about corporate governance and executive pay.) The revenue issue is peripheral, and is related to commitment issues; if the tax structure were certain to stay in place, then capital gains and dividends would be equivalent; however, so long as there is a possibility of lower capital gains rates in the future, there is an incentive to hold earnings in the corporation rather than to pay them out as dividends (and that aligns with managerial and exectutive incentives). In my view, from a social perspective, there is no reason to provide significant tax advantages to investments made by corporations (by letting them be made out of pre-tax income) relative to those made by individuals (out of post-tax income).

      1. I looked back at it and the intangibles tax issue in NC was different. That was a tax on the value of stocks, paid by consumers and it was judged to be unconstitutional by NC Supreme court. I think that it is unlikely politically to reduce the corporate tax rate unless it is greatly reduced, and wrapped up as part of a larger deal. The main key is developing a tax code that raises enough revenue, is consistent with economic growth and then is as fair as possible (and I realize fair is quite subjective) but we have to have that out as a country. When thinking about fairness the spending side is also key, particularly what we do or don’t do regarding health reform.

  6. Bruce Bartlett has been arguing for a VAT for donkeys years. Michael Graetz has argued that the first 100K of earned income be free of income tax, with the shortfall made up with a VAT. That’s a fairly simple (if partial) way of fixing the progressivity issue.

    I pretty much agree with Katja on the merits and demerits of the VAT, but have something to add. Its most salient characteristic is that it is nearly invisible to low-information voters. In the wrong hands, that’s a recipe for wildly regressive taxation. (Our Confederate states are particularly partial to sales taxes for just this reason.) In the left hands, it means we can more painlessly raise revenues without much opposition from the electorate, especially in Graetz’s plan.

    1. So, the left are the only ones with saintly hands and none that will do the devil’s work?

      1. That’s what they think, yeah: Transparency is only a virtue when the other guy is in power. Because they’re the good guys, they’ll only do good stuff, so lack of transparency can never be a bad thing, it simply makes it harder to stop them from doing good stuff.

        They really think that.

  7. A note from from long-Vatted Europe.
    – the least distorting tax possible if applied at a uniform rate (though as pointed out, in practice countries reintroduce “distorsions” on equity grounds);
    – creates the fewest problems and distorsions at tax borders (between European countries or US states) by the reclaim mechanism on intermediate purchases. In Europe, it’s not worth crossing a border to gain a couple of % VAT differential on an ordinary purchases;
    – forces businesses to use a good accounting metric (value added);
    – transparent to end consumers (contrast Brazil’s variable sales taxes, where nobody knows what the tax is on anything).
    – paperwork-heavy, especially for small businesses (but see penultimate pro point).

    1. Con: Lack of transparency allows government to put taxes at a higher rate than the public would agree to if they were aware how much they were really being taxed, by shifting the blame for high prices to retailers.

      Really, you’ve got to either put that in the cons, or explicitly state that the ability to mislead the public is a pro.

      1. Considering how ignorant our public is concerning our present tax system, I’m not sure that’s actually much of a con. We have lower tax rates than we’ve had in a long time, but something like half the country doesn’t understand that. A shocking number of people don’t understand the difference between marginal rate and effective rate.

        The VAT is more under the hood, so yes, in the abstract I agree there is a danger of it being less transparent. But our relatively more transparent system is grossly misunderstood. If you wanted to explain to the public how the VAT was making products expensive, how would that be any harder than present-day whining about the lowest federal income tax rates in the post-WWII era? That seems to work pretty well.

        I don’t much like the VAT because I worry about regressivity. Transparency is very much a secondary problem (though again, I agree it’s a potential issue).

      2. I don’t understand this. The VAT paid is printed on every bill, invoice, or till receipt, even if prices are quoted including VAT. As the rate is more or less uniform, in my experience people in Europe have a good general understanding of the burden (20% or a bit less). It’s a lot more comprehensible than income tax. The obscure part is under the hood: the reclaim system for tax on inputs is complicated, and a burden on businesses, as I recognized.

Comments are closed.